Abstract
This chapter describes methods that do not assume a perfect capital market—i.e. the following methods use differing debt and credit interest rates instead of a uniform discount rate: the compound value method, the critical debt interest rate method and the visualisation of financial implication (VoFI) method. As in the previous chapters the methods are described including a discussion of their assumptions and their applicability.
This is a preview of subscription content, log in via an institution to check access.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
References
Grob, H. L. (1993). Capital budgeting with financial plans: An introduction. Wiesbaden: Gabler.
Heister, M. (1962). Rentabilitätsanalyse von Investitionen. Köln: Westdeutscher Verlag.
Teichroew, D., Robichek, A. A., & Montalbano, M. (1965a). Mathematical analysis of rates of return under certainty. Management Science, 11(3), 393–403.
Teichroew, D., Robichek, A. A., & Montalbano, M. (1965b). An analysis of criteria for investment and financing decisions under certainty. Management Science, 12(3), 151–179.
Author information
Authors and Affiliations
Assessment Material
Assessment Material
1.1 Exercise 4.1 (Compound Value Method, Critical Debt Interest Rate Method and VoFI Method)
Two investment projects are available, with the following relevant cash flows:
-
(a)
Use the compound value method to decide which project to accept. Assume a credit interest rate of c = 5 % and a debt interest rate of d = 8 %. Calculate the compound values of the two projects, assuming:
-
(i)
Mandatory account balancing.
-
(ii)
Prohibited account balancing.
-
(i)
-
(b)
Calculate the critical debt interest rate, assuming:
-
(i)
Mandatory account balancing.
-
(ii)
Prohibited account balancing.
-
(i)
-
(c)
Assess the underlying assumptions and meaningfulness of the compound value method.
-
(d)
Assess the absolute profitability of project II above, using the visualisation of financial implications (VoFI) method. In so doing, assume that the opportunity interest rate is 6 % and the credit interest rate for short-term deposits is 5 %. The project is to be 20 % financed by internal funds. Thirty percent of the initial outlay is to be financed with an annuity loan (with annual interest and capital repayments, an interest rate of 8 % and a 5 year term). A further 30 % is financed by a loan repayable at the end of its term (with an initial payment at a ‘below par’ rate of 5 %, with annual interest payments, a nominal interest rate of 7 % and a 5 year term) and the remainder with a current account loan (10 % interest rate).
-
(e)
In the case of project II, what is the maximum amount that can be withdrawn at the end of each period of its economic life, taking the assumptions in d) as valid?
1.2 Exercise 4.2 (Dynamic Investment Appraisal Methods)
A choice has to be made between two investment projects. The following budgets are forecasted:
The uniform discount rate is 10 %.
-
(a)
Assess the alternatives using the net present value method. What is the net present value of the fictitious differential investment?
-
(b)
Calculate the internal rates of return for each investment project and draw the net present value curves.
Assess the relative profitability using the internal rate of return method.
-
(c)
Calculate the projects’ discounted payback period.
-
(d)
Now assume a debt interest rate of d = 0.12 and a credit rate of c = 0.08 for the next 4 years. Calculate the compound values of the projects, assuming:
-
(i)
Mandatory account balancing.
-
(ii)
Prohibited account balancing.
-
(i)
-
(e)
Calculate the critical debt interest rates, for each project, assuming:
-
(i)
Mandatory account balancing.
-
(ii)
Prohibited account balancing.
-
(i)
-
(f)
Assess the absolute and relative profitability of the two investment projects using the visualisation of financial implications (VoFI) method. In each case, €5,000 of internal funds should be used for financing. The opportunity interest rate is 9 % and the credit interest rate for short-term deposits is 7 %. Project I is financed with an instalment loan of €4,000 (interest of 11 %; annual interest payments calculated on the remaining balance; term matches the project’s economic life) and with a current account loan (annual interest payments at 13 %). In the case of project II there is an additional loan for €2,000, repayable at the end of its 4 year term (annual interest at 10 %).
Further reading: see recommendations at the end of this part.
Rights and permissions
Copyright information
© 2015 Springer-Verlag Berlin Heidelberg
About this chapter
Cite this chapter
Götze, U., Northcott, D., Schuster, P. (2015). Compounded Cash Flow Methods. In: Investment Appraisal. Springer Texts in Business and Economics. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-662-45851-8_4
Download citation
DOI: https://doi.org/10.1007/978-3-662-45851-8_4
Published:
Publisher Name: Springer, Berlin, Heidelberg
Print ISBN: 978-3-662-45850-1
Online ISBN: 978-3-662-45851-8
eBook Packages: Business and EconomicsBusiness and Management (R0)